AAM Corporate Credit View

November 2009

The demand for Corporate bonds, especially those with wider spreads, continues. The excess return for October (Barclays Corporate Bond Index – “Index”) was 89 basis points (bps) or 73 bps, excluding hybrids. Finance outperformed Utilities and Industrials, posting 162 bps of return vs. 56 bps and 47 bps respectively. The OAS was 206 bps at month-end compared to 555 bps at year-end 2008. Over the last 20 years, the low point (OAS) was 51 bps in July 1997, ranging from Utilities at 38 bps to Industrials at 58 bps. The yield at that time for the Index was 6.61%, very close to the 20 year mean of 6.74%. The yield for the Index at 10/28/09 was 4.78%, exemplifying the very low rate environment that we are in today.

A lot has changed since 1997. The size of the Index measured by the amount outstanding ($)has changed, growing 135% since 1997, while the number of issues has been reduced by 22% since 1997. This reflects the larger, more liquid deals that facilitate trading and hence, lead to more volatility. The participants in the Corporate market have also changed with a greater number of hedge funds and other trading oriented firms looking to Corporate bonds for investment opportunities (Exhibit 1). Oddly, two things have not changed. First, the credit rating of the Index remains A2/A3, and second, the primary sector composition is virtually the same.

Change and specifically, volatility become evident if one splits the last 20 years into decades. Table 1 shows the volatility of Corporate spreads over a 20 year period. Simply, the last 10 years have been less rewarding for bondholders than the prior 10. The annualized total return over the first 10 years for investors in the Index was 8.31% vs. 6.51% over the last 10. And, as you see below, the risk/reward has certainly been less favorable especially for Financials.

TABLE 1

1989-2009

1989-1999

1999-2009

OAS – Mean

Corporate

170

84

176

(bps)

Industrials

169

93

173

Utilities

173

71

179

Financials

172

90

176

OAS – Std Deviation

Corporate

113

23

114

Industrials

89

25

89

Utilities

103

19

103

Financials

156

35

159

OAS/Std Dev

Corporate

2

4

2

Industrials

2

4

2

Utilities

2

4

2

Financials

1

3

1

Source: Barclays

Putting the past behind us, the more important question is what can we expect over the next 10 years? Even though spreads have tightened considerably this year, we note that many sectors have not even approached the tights over the last two years let alone the last 10. It is evident from the graph (“Exhibit 2”) below that given the economic and government/fiscal uncertainty, the Corporate bond market continues to demand payment for sectors that are more vulnerable. We believe this higher dispersion around the mean will persist in the near-to-intermediate term or at least until the economy begins to improve organically.

Exhibit 2

The message rings clear to us. Spread volatility has increased and with default risk expected to remain high over a longer time period[note]Bank of America Merrill Lynch “From Matterhorn to Matanuska” 9/16/2009 – Predictions include: twin default peaks in late 2009and a lower peak in late 2012, a slower rate of improvement from the peak in 2012, cumulative defaults reaching 40% vs. 30% in previous cycles, and a slower return to below average default rates, specifically taking 7-8 years to fully play out vs. the 5-year normal cycle duration.[/note], credit selection is critical. We continue to believe investing defensively and not solely reaching for the highest yielding asset today is critical in this environment for both total return and principal and interest preservation. In 2010, we believe there will be periods of spread widening given our expectation for muted GDP growth, as the government stimulus wanes. Consequently, we generally favor sectors that will benefit from demand overseas, government support, and inventory restocking while avoiding those that are susceptible to event risk or heavily dependent on housing, commercial real estate and/or discretionary consumer spending.

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